The Federal Reserve Bank unveils plan for quantitative tightening : Planet Money : The Indicator from Planet Money To try and slow inflation, the Federal Reserve is going beyond its typical tool of raising interest rates, and adopting a policy of "quantitative tightening." So ... what is that, exactly?

Quantitative easing, meet quantitative tightening

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SYLVIE DOUGLIS, BYLINE: NPR.

(SOUNDBITE OF DROP ELECTRIC SONG, "WAKING UP TO THE FIRE")

ADRIAN MA, HOST:

If the Fed has one main tool for fighting inflation, it's the ability to control interest rates. Interest rates are to the Fed what the magic wand is to Harry Potter or the heart-shaped herb is to Black Panther.

DARIAN WOODS, HOST:

What square pants are to SpongeBob.

MA: Yes.

WOODS: And that is why the U.S.' central bank, the Federal Reserve, announced today that it is hiking its interest rates a half percent. Last time that happened was more than 20 years ago. And today, we're going to talk about another tool that was part of today's announcement.

MA: Right. We're going to focus on a lesser-known tool - a relatively untested tool called quantitative tightening. This is THE INDICATOR FROM PLANET MONEY. I'm Adrian Ma.

WOODS: And I'm Darian Woods. Today on the show, we're going to explain everything quantitative tightening - what it is, how it works, and why even the people whose job it is to follow this stuff, like bankers, economists, investors...

MA: Podcasters.

WOODS: ...Maybe - especially podcasters - are not sure whether this will help cool inflation or derail the economy completely.

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MA: It is a lot easier to understand quantitative tightening if you first take a look at, well, its predecessor - quantitative easing.

WOODS: Quantitative easing - this is a phrase that first entered the lexicon in 2009. At the time, the Great Recession was in full effect. The housing bubble had burst. The banks and the financial institutions were holding tons of these things called mortgage-backed securities. These were essentially bonds made out of home loans. And you might remember, at the time, a lot of these were underwater, and they were toxic.

MA: And so these banks and financial institutions, they looked at the Fed and were like, you got to do something. Raghu Rajan is professor of finance at the University of Chicago, and he explains what happened next.

RAGHURAM RAJAN: So one thing the Fed did was to go in and buy mortgage-backed securities in an attempt to essentially refloat the market, to make it sort of, you know, emerge from the dead.

WOODS: And to do that, it needed to come up with the money. But, you know, if you're a central bank, you control the printing press. It's actually easier to do than you might think.

MA: Yeah. Yeah. What comes to mind, actually, is this, the money printer go brrr (ph) meme. I don't know if you've seen it.

WOODS: Yes - well-known economics meme in the internet. Yeah.

MA: My favorite version of it is a whale in a suit that is, like, cranking out this printing press, and it's, like, literally shooting out dollar bills.

WOODS: And it is kind of like that, except instead of printing money, the Fed opened up its Fed computer and created the money digitally. The government took that digitally minted cash, and they bought hundreds of millions of dollars' worth of these mortgage-backed bonds.

RAJAN: That was when quantitative easing really started. But once it did that, basically it said, well, maybe there are other ways this can help.

MA: And the economy still needed a lot of help. I mean, it was kind of languishing. People were losing jobs. And, you know, normally, when the Fed wants to boost the economy, it uses its main tool, the Fed funds rate - basically this rate upon which other banks and lenders base their interest rates. And so normally, if the Fed turns its rate down, it has the effect of making these loans cheaper. And hopefully, businesses are more likely to invest, and people are more likely to buy stuff.

RAJAN: That's typically how monetary policy works. But what happens if you've got interest rates down to zero? How do you get activity going? And that's where the Federal Reserve started becoming innovative.

WOODS: In 2008, the interest rate was about as low as it could possibly be without going negative. Like, it was around 0%. And so the Fed instituted more quantitative easing - more QE buying up assets. But this time, the objective was not so much to buy up all the toxic mortgage securities but was more about pumping more cash into the economy in general.

MA: Right. The government was basically saying to banks, we will buy your toxic bonds and a whole bunch of other bonds, too. And in exchange, you, the banks, will get cash. And just pretty please just do something with it. Like, make a loan. Invest in something.

WOODS: Live your dreams of being a kayak tour guide on a lake somewhere.

MA: Well, maybe not that kind of thing - but basically, they were just like, don't just sit on this cash.

RAJAN: That's a fair description of what they were trying to do - at least one way it was supposed to work, yes. The problem, to some extent, is we're not quite sure how it works and, in fact, whether it really works. These are all theories.

MA: Believe it or not, the research is kind of mixed on just how much quantitative easing helped the economy recover from the Great Recession. Still, when the pandemic hit in 2020, the Fed turned to QE once again. Mark Cabana is an investment strategist at Bank of America, and he remembers early on, investors were freaked out.

MARK CABANA: Everybody was dashing for cash and wanting to be safe and wanting to be liquid. And the Fed knew that, and they took it upon themselves to try and clear the pipes.

WOODS: So the Fed started buying hundreds of millions of dollars' worth of more bonds. They were injecting more cash into the system. Mark says that that was essential in keeping the financial system afloat.

MA: And it's worth mentioning here that the Fed isn't just, like, giving away money, right? The money is out there because it paid it in exchange for bonds. And so as a result of this latest round of quantitative easing and all the QE before it, it had stockpiled all of these assets it didn't have before. And so its balance sheet - basically its personal ledger - just ballooned.

CABANA: Prior to the great financial crisis, the Fed always had a balance sheet, just like all entities do, but it was quite small.

MA: Through multiple rounds of QE, the Fed's balance sheet grew from around 800 billion before the Great Recession to, today, around 9 trillion. And just for scale, that's almost 40% of last year's GDP.

WOODS: But now the Fed is looking to shrink its balance sheet. And so, listener, we arrive at the thing that we have promised at the start of the show - quantitative tightening. If quantitative easing was about revving up the economy, quantitative tightening is about slamming on the brakes.

MA: Instead of buying bonds, starting in June, the Fed will be unloading them. And initially, it will do this by letting bonds mature. So for instance, if they have a 15-year bond and it's turning 15 years old in June, they'll basically redeem it for cash. And later on, the Fed says it may also sell bonds. Either way, bonds end up back in the market. And that digital money machine we talked about earlier - that'll be thrown into reverse. So instead of injecting money into the system, QT will suck money out at a rate of roughly $95 billion a month when it fully gets going.

WOODS: Money machine now goes (imitating slurping).

CABANA: And when the Fed receives the money, they destroy it. The Fed just destroys the money, and their balance sheet declines. Poof, it's gone, right? So it's like you're, you know, the whale in the suit just going the other way. Think vacuum - right? - not printing press this time.

MA: Yeah. Mark saw the meme, too.

WOODS: This meme has good coverage. And in addition to hoovering up the cash, Raghu from the University of Chicago says that the Fed unloading its stockpile of bonds will also push up interest rates. And the hope there is that that will spread to the entire economy.

RAJAN: Raise mortgage rates, make it harder to buy houses, make it harder to invest and, thereby, by slowing activity somewhat, you know, bring down inflation.

MA: That, at least, was the idea. Raghu says the Fed now is kind of operating in uncharted territory - right? - 'cause the last time it tried quantitative tightening was around 2017, and the stakes then didn't seem as high as they are now. Back then, inflation was really low.

WOODS: Now inflation is running super hot, and we're still in a pandemic. Supply chains are messed up everywhere, and the Fed is raising interest rates really fast. And so with all of this, this increases the chance that it could tip the U.S. economy into a recession. It's almost like trying to stop a car that is going too fast.

RAJAN: You're going at a tremendous speed at this point, and you're a little worried that the foot brake is not enough. And so you are applying the emergency brake. You have less of a sense of how the emergency brake works at such breakneck speeds. And, you know, you hope and pray that it works as it works at slow speeds, but you're not quite sure.

MA: Yeah. Hopefully, quantitative tightening will slow the economy down without sending it into a skid.

(SOUNDBITE OF NAY JAY'S "WILD THOUGHTS")

WOODS: This show was produced by Jamila Huxtable with help from Josh Newell. It was fact-checked by Nicky Ouellet. Viet Le is our senior producer, and Kate Concannon edits the show. THE INDICATOR is a production of NPR.

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